an economic journey

Monday, July 25, 2005

Realistic Growth Rates for Financial Portfolios

According to Ibbotson Associates (www.ibbotson.com), the historical (1926-2000) growth rate on the S&P 500 has been in the range of about 10.7% per year. This represents a nominal measure that includes capital gains, retained earnings and the reinvestment of dividends paid. In real terms (adjusting for inflation -- the percentage change in the Consumer Price Index) this growth rate is roughly 7.7% per year (10.7% - 3.0 annual rate of inflation).

This started me thinking about how long it would take for someone with an average net worth, say around $50,000, to turn this sum into something significant. What would be a significant accumulation? How about the value of U.S. Gross Domestic Product 'GDP'?

Historically, Real GDP (RGDP -- growth in the output of an economy) in the U.S. grows at a rate of about 3% per year and stands at a value of $11,100,000,000,000 ($11.1 trillion).

Now given the nature of compound growth, it is only a matter of time before a smaller sum growing at a roughly 8% annual rate exceeds a much larger sum growing at a lower rate. How long will it take before my $50,000 will allow me to purchase all of the U.S. GDP? We can compute the answer using the following:

$50,000(1.08)N = $11,100,000,000,000(1.03)N

solving for 'N' we have:

(1.08)N / (1.03)N = $11,100,000,000,000 / $50,000

or

[(1.08)/(1.03)]N = $222,000,000

[1.0485]N = $222,000,000

or

log1.0485[222,000,000] = N

or

ln(222,000,000)/ln(1.0485) = N = 406 years!

Now I won't be around 400 years from now. According to these numbers, If I put $50,000 into the stock market today and am able to earn the historical rate of return of 8% per year, my descendants will be able to purchase the whole of U.S. GDP at that time. Too bad for the other 350 million people in the U.S. economy that try to buy food, housing, or education for their kids.

I realize that individual's do not just cash in their financial assets at a single point in time and go on a spending spree. However, as we talk about the stock market as a vehicle for Social Security Privatization, retirees in increasing numbers are going to do exactly that -- cash in. The value of these assets is based on the ability to convert this financial wealth in to real goods and services if someone chose to do so -- real goods and services produced and provided by an economy growing at a rate of roughly 3% per year.

Thus, I believe that eventhough it is possible for some investors to realize a rate of return of 8% or more, as we talk about large segments of the population building portfolios the realistic rate of return must be closer to the actual rate of economic growth -- 3%.

Growth in the U.S. Federal Debt

Growth in the federal debt bothers me. I believe that the federal government should not be competing with the private sector for resources. Yes, there is the argument that these are unusual times with 9/11, the war on terror, and homeland security concerns. But even prior to 2001, the U.S. was sitting on a $5.9 trillion debt – debt that was accumulated in part because of the unusual events of the 1980’s such as the need for tax cuts to stimulate the economy after the 1981-82 recession, the Cold War (defeating the evil empire), and prosecuting the first Gulf War. Would American citizens have been as accepting of the need to borrow then if they knew of the possibility of the events of September 11, 2001?

By allowing our government to borrow significant sums today, we are saying that the problems of today are more important than problems that might emerge in the future. In ten years, will the United States be able to face the threats imposed by a new world super-power if we are sitting on a federal debt equal to 100% of GDP? Even if you don’t buy that argument, by allowing our government to borrow, we are allowing our elected leaders to provide us with politically attractive tax cuts without taking responsibility for politically-distasteful spending cuts. Elected leaders basically saying that we can keep more of “our” money and also continue to enjoy all the services we have come to expect from our public sector. We just send the bill to our children.

The economy has been growing for three years now. If wage and salary income is stagnant, then this growth in income must be accruing to rents, interest, and profits. And yet we find that the match between buyers and sellers of corporate shares of stock is fairly evenly matched as evidenced by little net change in the major indices (DJIA, NASDAQ, and S&P). Investors (savers) are not eagerly seeking to share in ownership of listed companies. These business firms, although profitable are not eager to invest in new capital or capacity. Economists do point out that the balance sheets of these companies are quite strong – strong in that they are sitting on massive amounts of cash (One pundit asked if a particular computer company was truly a member of the high-tech industry or a credit union). This cash however is not sitting in the form of greenbacks stashed away in safety deposit boxes. Instead prudent financial managers of these firms maintain liquidity and asset safety by buying Treasuries (i.e., federal government debt instruments).

Presently the Federal government represents the best use of savings and investment funds – an unusual characteristic for the U.S. economy over the past 3 – 4 years. This is evidenced by the fact that short-term and medium-term yields on treasuries have held constant and longer-term yields (an on the 10 year note) have near historical lows (4.2% as of October 8, 2004). One would expect that with the federal government borrowing an additional $2 trillion since May 2002, that interest rates and yields should rise. But, there is little competition for loanable funds. The private sector either has few investment opportunities or savers are seeking the safety of government liabilities given a continued distrust of equity markets (given recent experience with Tyco, Worldcom, Qwest, Sunbeam, and others). Is preference for lending to the public sector rather than the private sector desirable in what most people consider to be the best example of a market-driven economy on the planet?

Interest payments to foreign owners of U.S. Federal Debt

According to the current Treasury Bulletin (www.fms.treas.gov/bulletin/b25ofs.doc), foreign and international ownership of the federal debt totals $2,037 billion. At an annual interest rate of 4% (perhaps a bit high), U.S taxpayers must pay these foreign owners of U.S treasury instruments $81,480,000,000 ($81.5 billion) each year in interest payments. As we worry about our current account deficit which stood at roughly $680 billion last year we should be mindful that over 10% of this value is in the form of these interest payments rather than for imported goods and services.

With the trade imbalances with China in the news we might note that the Chinese government and institutions own roughly $280 billion of the U.S. federal debt. We are paying $11.2 billion in interest payments each year or about $10 to each Chinese citizen for their assistance in financing our accumulating budget deficits.

Interest on the Federal Debt

As of July 25, 2005, the federal debt stood at $7,868.6 billion. The interest expense for the fiscal year 2004-2005 (October 1, 2004 through June 30, 2005) stands at $299 billion -- a bit more than $100 billion less than the U.S. defense budget. What I find remarkable is that for the current fiscal year this interest expense exceeds the current budget deficit of $249.8 billion. While the deficit numbers are less than a year ago and improving, the interest expense is much greater. One economic problem facing the U.S. into the near future is not the size of these deficits but the growing interest payment on the existing debt. Right now every woman, man and child in the U.S. (current population = 296.7 million) must pay roughly $1,000 in taxes each year to accomodate this interest burden.